Medcraft's hybrid nightmare is almost reality

In his final months as ASIC chairman in 2017, Greg Medcraft began lobbying for a ban on hybrid securities being marketed to retail investors.

Medcraft advanced the argument in several interviews with the AFR and in his final appearance before the Senate Estimates Committee in which he described hybrids as a "ridiculous" investment for retail investors and a "ticking time bomb" in the financial system.

"They are banned in the United Kingdom for sale to retail (customers)", the former ASIC boss told the Senate in October 2017.

"I am very concerned that people don't understand, when you get paid 400 basis points over the benchmark, that is extremely high risk, and I think that, because they are issued by banks, people feel that they are as safe as banks.

"Well, you are not paid 400 basis points for not taking risks, and I do think this is, frankly, a ticking time bomb."

There has been plenty of talk among financial advisers this week about the problematic structure of hybrids and whether they are appropriate for retail investors.

NAB's decision last night to abandon a planned A$2 billion hybrid issue indicates that investors might no longer be prepared to buy in to the uncertain risks they carry.

One of Medcraft's big concerns was that retirees and other small investors who had bought hybrids issued by banks for their relatively high yields did not appreciate that so-called "trigger clauses" allowed financial institutions to hasten the conversion of their investments to ordinary shares.

Banks, Medcraft feared, would have big incentives to convert these investments from debt to equity during periods when share prices were on the nose and conventional sources for raising capital had dried up.

Recent tumult on the ASX and global share markets indicate that financial institutions may have entered such a period.

The collapse of major and regional bank share prices in the last three weeks has fuelled concern that banks will be constrained in their ability to raise capital, especially given social  expectations that they will suspend interest payments from troubled business borrowers over the next six months as the Covid-19 virus crunches economic activity.

While that might help the broad economy ride out  the disruption, the capital requirements imposed on banks are not likely to change.

Banks will be required to continue raising fresh capital to support lending growth and to fund expected blowouts for provisioning against non-performing loans.

In the current market environment banks stand little chance of executing capital raisings without offering fat discounts to their already battered share prices.

If the economic dislocation wrought by the global virus sparks a profound slide in credit quality, banks might have no option but to bring forward the conversion of up to $35 billion worth of hybrid securities.

On the surface that might be expedient for a collection of capital-starved banks in a bear market.

But it might also horrify a swathe of investors confronted by realisation that a perceived debt asset has turned prematurely into equity in companies that might struggle to pay them dividends.

That was Medcraft's nightmare scenario -  where banks effectively bail-in thousands of reluctant new hybrid security holders - to shield their balance sheets and regulatory capital positions.

The trading value of bank-issued hybrid securities has been crunched on the ASX this week as financial advisers have begun to alert retail clients to risks attached to their investments.

That was one of the reasons why NAB last night pulled a $2 billion hybrid issue announced last month.

"NAB recognises that market conditions have changed substantially since the offer was launched and that the ongoing market volatility would be likely to impact on the trading value of the NAB Capital Notes 4," the bank said in an ASX filing.

"NAB considers that the withdrawal of the offer is in the best interests of relevant stakeholders, including the large number of retail investors who had expressed interest in participating in the offer.

"Other options, including potential repricing, were not considered appropriate in the absence of an orderly market."